Financial ratios and their use in understanding Financial Statements
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An introduction and in-depth understanding on the importance of Financial ratios in understanding financial statements of business entities along with relevant examples
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Financial ratios and their use in understanding Financial Statements
- 1. Financial Ratios and their use in understanding Financial Statements Speaker: Pranav N Dedhia CA Final Student BCAS Study Circle: 19/03/2015 1 Financial Ratios
- 2. Flow of the presentation Financial Ratios 2 Introduction to Fundamental Analysis What is Ratio Analysis? Categories of Financial Ratios DuPont Analysis Other important points Q&A
- 3. Fundamental Analysis A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management). The end goal of performing fundamental analysis is to produce a value that an investor can compare with the security's current price, with the aim of figuring out what sort of position to take with that security (underpriced = buy, overpriced = sell or short). Financial Ratios 3
- 4. Basic steps in Fundamental Analysis • Step 1. Acquire the company’s financial statements for several years • Step 2. Quickly scan all of the statements to look for large movements in specific items from one year to the next • Step 3. Examine the Balance Sheet, Income statement and Cash Flow Statement • Step 3. Calculate financial ratios for each year (all categories of ratios) • Step 4. Obtain data for the company’s key competitors, and data about the industry, company’s stock price, dividend payout, etc • Step 5. Review all of the data that you have generated At this point… • You will probably find that there is a mix of positive and negative results. Answer the following question: • “Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will influence the company in the future, do I think this company is worth investing in for the long term?” 4 Financial Ratios
- 5. Ratio Analysis Ratio-analysis means the process of computing, determining and presenting the relationship of related items and groups of items of the financial statements. They provide in a summarized and concise form of fairly good idea about the financial position of a unit. They are important tools for financial analysis • A ratio is a relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==> A is 1.5 times B • A given ratio is compared to: 1. Ratios from previous years for internal trends 2. Ratios of other firms in the same industry for external trends Ratio Analysis acts as diagnostic tool that helps to identify problem areas and opportunities within a company. They provide an insight into company’s liquidity, profitability, financial leverage, efficiency and value 5 Financial Ratios
- 6. Ratio Analysis Before looking at the ratios there are a number of cautionary points concerning their use that need to be identified : • The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn • The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results • In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required The utility of ratio analysis will get further enhanced if following comparison is possible. 1. Between the borrower and its competitor 2. Between the borrower and the best enterprise in the industry 3. Between the borrower and the average performance in the industry 4. Between the borrower and the global average 6 Financial Ratios
- 7. How a Ratio is expressed? • As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales. • As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. • As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales. 7 Financial Ratios Classification of Ratios Balance Sheet Ratio P&L Ratio or Income/Revenue Statement Ratio Balance Sheet and Profit & Loss Ratio Financial Ratio Operating Ratio Composite/Mixed Ratio Current Ratio Quick Asset Ratio Proprietary Ratio Debt Equity Ratio Gross Profit Ratio Operating Ratio Expense Ratio Net profit Ratio Stock Turnover Ratio Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors’ Turnover Ratio,
- 8. Categories of Ratios Category Description Activity Ratios Measures how efficiently a company performs day to day tasks, such as the collection of receivables and management of inventory Liquidity Ratios Measures the company’s ability to meet its short term obligations Solvency Ratios Measures a company’s ability to meet long term debt obligations. Subsets of these ratios are known as “leverage” and “long term debt” ratios Profitability Ratios Measures the company’s ability to generate profitable sales from its resources (assets) Valuation Ratios Measures the quantity of an asset or flow associated with ownership of a specified claim Coverage Ratios Measures a company's ability to pay its liabilities 8 Financial Ratios
- 9. Commonly used Activity Ratios Activity Ratios Numerator Denominator Inventory turnover Cost of goods sold Average inventory Days of inventory in hand Number of days in period Inventory turnover Receivables turnover Revenue Average receivables Days of sales outstanding Number of days in period Receivables turnover Payables turnover Purchases Average trade payables Number of days of payables Number of days in period Payables turnover Working capital turnover Revenue Average working capital Fixed asset turnover Revenue Average net fixed assets Total asset turnover Revenue Average total assets 9 Financial Ratios
- 10. Commonly used Liquidity Ratios Liquidity Ratios Numerator Denominator Current ratio Current assets Current liabilities Quick ratio Cash + short term marketable investments + receivables Current liabilities Cash Ratio Cash + short term marketable investments Current liabilities Defensive intervals ratios Cash + short term marketable investments + receivables Daily cash expenditures Additional Liquidity Measures Cash conversion cycle (net operating cycle) = Days of inventory on hand + days of sales outstanding – number of days of payables 10 Financial Ratios
- 11. Commonly used Solvency Ratios Solvency Ratios Numerator Denominator Debt Ratios Debt to assets ratio Total debt Total assets Debt to capital ratio Total debt Total debt + Total shareholders equity Debt to equity ratios Total debt Total shareholders equity Financial leverage ratios Average total assets Average total equity Coverage Ratios Interest coverage EBIT Interest payments Fixed charge coverage EBIT + lease payments Interest payments + lease payments 11 Financial Ratios
- 12. Commonly used Profitable Ratios Profitability Ratios Numerator Denominator Return on Sales Gross profit margin Gross profit Revenue Operating profit margin Operating income Revenue Pretax margin EBT Revenue Net profit margin Net income Revenue Return on Investment Operating ROA Operating income Average total assets ROA Net income Average total assets Return on total capital EBIT Short and long term debt and equity ROE Net income Average total equity Return on common equity Net income – preferred dividend Average common equity 12 Financial Ratios
- 13. Valuation Ratios Valuation Ratios Numerator Denominator P/E Ratio Price per share Earnings per share P/B Ratio Price per share Book Value per share EV/EBITDA Ratio Enterprise Value EBITDA PEG Ratio PE Ratio EPS Growth Rate 13 Financial Ratios
- 14. Coverage Ratios Coverage Ratios Numerator Denominator Interest Coverage Ratio EBIT Interest Expense Fixed Charge Coverage Ratio EBIT + Fixed charges before tax Fixed charges before tax + Interest Debt Service Coverage Ratio Operating Income Total Debt service costs Financial Ratios 14
- 15. DuPont Analysis The Dupont analysis also called the Dupont model is a financial ratio based on the return on equity ratio that is used to analyze a company's ability to increase its return on equity. In other words, this model breaks down the return on equity ratio to explain how companies can increase their return for investors. The Dupont analysis looks at three main components of the ROE ratio. 1.Profit Margin 2.Total Asset Turnover 3.Financial Leverage Based on these three performances measures the model concludes that a company can raise its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively. 15 Financial Ratios
- 16. The DuPont Formulas • The DuPont formula uses the relationship among financial statement accounts to decompose a return into components. • Three-factor DuPont for the return on equity: ▫ Total asset turnover ▫ Financial leverage ▫ Net profit margin • Five-factor DuPont for the return on equity: ▫ Total asset turnover ▫ Financial leverage ▫ Operating profit margin ▫ Effect of nonoperating items ▫ Tax effect Return on Equity Net Profit Margin Operating Profit Margin Effect of Nonoperating Items Tax Effect Total Asset Turnover Financial Leverage 16 Financial Ratios
- 17. DuPont Analysis Return on Equity Return on Asset Net Profit margin Tax burden Interest Burden EBIT margin Total Asset Turnover Financial leverage 17 Financial Ratios
- 18. Five-Component DuPont Model 18 Financial Ratios
- 19. Example Consider two companies A Ltd and Z Ltd Both of these companies operate in the same apparel industry and have the same return on equity ratio of 45 percent. This model can be used to show the strengths and weaknesses of each company. Each company has the following ratios: Ratio Sally Joe • Profit Margin 30% 15% • Total Asset Turnover .50 6.0 • Financial Leverage 3.0 .50 Calculate the ROE Financial Ratios 19
- 20. Analysis As you can see, both companies have same ROE • A Ltd ROE = .30*.50*3.0 = 45% • Z Ltd ROE = .15*6.0*.50 = 45% A Ltd is generating sales while maintaining a lower cost of goods as evidenced by its higher profit margin. It is having a difficult time turning over large amounts of sales. Z Ltd’s business, on the other hand, is selling products at a smaller margin, but it is turning over a lot of products. You can see this from its low profit margin and extremely high asset turnover. This model helps investors compare similar companies like these with similar ratios. Investors can then apply perceived risks with each company's business model. Financial Ratios 20
- 21. Summary • Financial ratio analysis and common-size analysis help gauge the financial performance and condition of a company through an examination of relationships among these many financial items. • A thorough financial analysis of a company requires examining its efficiency in putting its assets to work, its liquidity position, its solvency, and its profitability. • We can use the tools of common-size analysis and financial ratio analysis, including the DuPont model, to help understand where a company has been. • We then use relationships among financial statement accounts in pro forma analysis, forecasting the company’s income statements and balance sheets for future periods, to see how the company’s performance is likely to evolve. 21 Financial Ratios
- 22. This is not the end… • List of Ratios not exhaustive • Numbers provide indicators • Financial indicators vary from industry to industry • Financial analysis is an art 22 Financial Ratios
Hinweis der Redaktion
- Fundamental analysis is about using real data to evaluate a security's value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for just about any type of security. For example, an investor can perform fundamental analysis on a bond's value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings. For assessing stocks, this method uses revenues, earnings, future growth, return on equity, profit margins and other data to determine a company's underlying value and potential for future growth. In terms of stocks, fundamental analysis focuses on the financial statements of the company being evaluated. One of the most famous and successful fundamental analysts is the Oracle of Omaha, Warren Buffett, who is well known for successfully employing fundamental analysis to pick securities. His abilities have turned him into a billionaire.
- Steps of Fundamental Analysis Step 1. Acquire the company’s financial statements for several years. These may be found in your assigned case study; in a recent annual report; in the company’s 10K filing on the SEC’s EDGAR database; or from other sources. As a minimum, get the following statements, for at least 3 to 5 years. · Balance sheets · Income statements · Shareholders equity statements · Cash flow statements Step 2. Quickly scan all of the statements to look for large movements in specific items from one year to the next. For example, did revenues have a big jump, or a big fall, from one particular year to the next? Did total or fixed assets grow or fall? If you find anything that looks very suspicious, research the information you have about the company to find out why. For example, did the company purchase a new division, or sell off part of its operations, that year? Step 3. Review the notes accompanying the financial statements for additional information that may be significant to your analysis. Step 4. Examine the balance sheet. Look for large changes in the overall components of the company's assets, liabilities or equity. For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? Has the proportion of debt grown rapidly, to reflect a new financing strategy? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 5. Examine the income statement. Look for trends over time. Calculate and graph the growth of the following entries over the past several years. · Revenues (sales) · Net income (profit, earnings) Are the revenues and profits growing over time? Are they moving in a smooth and consistent fashion, or erratically up and down? Investors value predictability, and prefer more consistent movements to large swings. For each of the key expense components on the income statement, calculate it as a percentage of sales for each year. For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales. Look for favorable or unfavorable trends. For example, rising G&A expenses as a percent of sales could mean lavish spending. Also, determine whether the spending trends support the company’s strategies. For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development. Look for non-recurring or non-operating items. These are "unusual" expenses not directly related to ongoing operations. However, some companies have such items on almost an annual basis. How do these reflect on the earnings quality? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 6. Examine the shareholder's equity statement. Has the company issued new shares, or bought some back? Has the retained earnings account been growing or shrinking? Why? Are there signals about the company's long-term strategy here? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 7. Examine the cash flow statement, which gives information about the cash inflows and outflows from operations, financing, and investing. While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about. If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 8. Calculate financial ratios in each of the following categories, for each year. You may use the formulas found in your textbook, or other materials you have from your finance and accounting courses. A summary of some useful ratios appears at the end of this document. · Liquidity ratios · Leverage (or debt) ratios · Profitability ratios · Efficiency ratios · Value ratios Graph the ratios over time, to find the trends in the ratios from year to year. Are they going up or down? Is that favorable or unfavorable? This should trigger further questions in your mind, and help you to look for the underlying reasons. Step 9. Obtain data for the company’s key competitors, and data about the industry. For competitor companies, you can get the data and calculate the ratios in the same way you did for the company being studied. You can also get company and industry ratios from the Quicken.com Evaluator, Schwab Stock Evaluator, or other locations on my LINKS website. Compare the ratios for the competitors and the industry to the company being studied. Is the company favorable in comparison? Do you have enough information to determine why or why not? If you don’t, you may need to do further research. Step 10. Review the market data you have about the company’s stock price, and the price to earnings (P/E) ratio. Try to research and understand the movements in the stock price and P/E over time. Determine in your own mind whether the stock market is reacting favorably to the company’s results and its strategies for doing business in the future. Review the evaluations of stock market analysts. These may be found at any brokerage site, or from various locations on my LINKS website. Step 11. Review the dividend payout. Graph the payout over several years. Determine whether the company’s dividend policies are supporting their strategies. For example, if the company is attempting to grow, are they retaining and reinvesting their earnings rather than distributing them to investors through dividends? Based on your research into the industry, are you convinced that the company has sufficient opportunities for profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends? Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends? Step 12. Review all of the data that you have generated. You will probably find that there is a mix of positive and negative results. Answer the following question: “Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will influence the company in the future, do I think this company is worth investing in for the long term?”
- LOS: Calculate and interpret variations of the DuPont expression and demonstrate use of the DuPont approach in corporate analysis. Pages 372–382 The DuPont Formulas Return on equity Net profit margin Operating profit margin Effect of nonoperating items Tax effect Total asset turnover Financial leverage
- LOS: Calculate and interpret variations of the DuPont expression and demonstrate use of the DuPont approach in corporate analysis. Pages 378–379 Five-Component DuPont Model The DuPont formulas involve the income statement and balance sheet relationships. Starting with the return on equity, we can break the return on assets component into its own components to get a better idea of what drives the return.
- 5. Summary